Niall Ferguson

Martin Wolf in today’s Financial Times absolutely nails the essentials of the current debate breaking out over our national debt and the federal deficit. I completely endorse his point of view.

I can understand people who are not involved in economic policy discussions making the mistake that we ought to deal with our deficit as a matter of urgency – it seems intuitive that nation’s should balance their books in the way that private citizens have to. But I am shocked at the irresponsibility of some who participate in the discussion and advocate fiscal tightening without thinking through the consequences.

And it isn’t as if we have no empirical support for the debate: presumably 1937 means nothing to the minds of the fiscal hawks who are now clamoring for tightening.

This is odd, since the hawks are being led by Niall Ferguson who is an internationally known historian. I could not disagree with his reading of the history more. My explanation for Ferguson’s mistake is that he is in the thrall of Milton Friedman’s famous interpretation of the Great Depression which placed the blame for the disaster on the Federal Reserve Board and its poorly timed tightening of monetary policy. Such was the influence that Friedman had that even as recently as the mid 2000’s, at an appreciation dinner, Bernanke told him that the Fed was sorry for its mistakes and would not repeat them.

This is important because Friedman’s analysis opened the door to subsequent attacks on Keynesian style deficit spending. The logical conclusion of the Friedman thesis was that the Depression was a monetary policy induced error and that fiscal policy as advocated by Keynes was irrelevant, and may indeed be harmful.

Friedman should not be blamed entirely for the current malaise in the economic policy debate since it was his followers who pressed the logic to its limits and have now developed the view that fiscal policy can never be effective – Nobel Prize winner Robert Lucas’ so-called ‘rational expectations’ theory tells us that consumers and firms immediately change their behavior when the government runs a deficit to take into account the future taxes needed to pay down the debt created by that deficit. The effect of this changed behavior is to induce extra savings which offset exactly the stimulus effect intended by the deficit. Thus fiscal policy is useless.

This is what appears to be Ferguson’s position. So he can assert that the damage done by accumulating debts and the chances of impending financial market chaos necessitate fiscal tightening, and that we should put the entire burden of economic management on monetary policy. He takes advantage of the Greek crisis and tries to characterize it as a portent of our future if we don’t tighten the budget up.

This is just nonsense.

There is no comparison between the US and Greece that makes any sense whatever. Ferguson is simply using Greece as an opportunity to trot out the fiscal hawk position he has been advocating since the crisis began. It made no sense then and it makes less sense now. It is tiresome to have to keep trumpeting the efficacy of fiscal stimulus. It is even more tiresome, but important, to have to keep rebutting people like Ferguson who advocate poor economics.

Let me recapitulate the major point that Wolf makes: the private sector has shifted from net debt accumulation to net savings. From negative 2.1% to positive 6.7%. That implies an equally dramatic shift in consumption, which collapsed by the 8.8% difference between those two numbers. That creates a huge gap in the economy we need to fill temporarily. Hence fiscal stimulus.

This does not imply we should not concern ourselves with the medium term: the deficit looms large as our most significant medium term problem, but as Wolf successfully argues it is not a short term problem at all. Put another way, the medium term cost of running a deficit is much less than the near term cost of not kick-starting the economy.

That means we keep the peddle pressed down firmly on stimulus and ignore people like Ferguson. He should stick to history and stay away from economics.

A more sophisticated argument against a policy of general stimulus is given by Bradford Cornell a professor of financial economics at Cal Tech. His point is that since a stimulus is inevitably a generalized policy – it lacks precision – and the problem is one of what he calls ‘misalignment’ which requires a precise response, we should abandon stimulus and focus instead on microeconomic solutions such as improving the allocative ability of the financial sector. Although it might appear to be very different Cornell’s approach is informed by the same neo-classical economics that Ferguson is advocating.

The notion that tinkering with removing micro level blockages in order to ensure the allocation of resources within a economy is most ‘efficient’ is straight from the Friedman/Lucas playbook. It assumes that macro level discussions of things such as ‘aggregate demand’ are irrelevant – Cornell comes right out and dismisses the very concept of aggregate concepts. This leads him to object to anything remotely Keynesian since Keynes’ entire approach is based upon aggregate analysis.

I find Cornell’s analysis less objectionable only to the extent that his idea that we should be able to wind up banks more easily, and thus ensure banking efficiency in the long run, an acceptable addition to any new re-regulation of the industry. It is not, however, a substitute for macro level stimulus.

Now is not the time for tinkering in the Cornell model. We need more stimulus.